week4 - capital budgeting 1 - exeterpeople.exeter.ac.uk/wl203/beam013/materials/week4 -...
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Week 5 2
Project valuation
Today, you are going to value the following project.
Initial cost of the project: £2.5m to be invested immediately.
The best projection for the number of items sold for the next
seven years is (with nothing after this):
Year 1 2 3 4 5 6 7
Sales 10000 20000 22000 24200 24200 12100 0
Next year you expect to be able to sell these items at £100
each. There is a fixed cost of production each year of
£500,000 and a variable cost of production of £25 an item.
You pay no corporate tax
The risk-free rate currently stands at 5% and inflation is at
3%. You believe that these cashflows should be discounted at
a risk premium of 8%.
Week 5 3
Cashflows
The first thing you must do is to calculate the net cashflow.
Now, it is very important that you remember to include the
inflation component when calculating the cashflows. If you
don’t do this, you will be in trouble.
Year 0 1 2 3 4 5 6
Invested
(£m)
(2.50)
Sales 10000 20000 22000 24200 24200 12100
T/o (£m) 1.00 2.06 2.33 2.64 2.72 1.40
Fixed
cost (£m)
(0.50) (0.52) (0.53) (0.55) (0.56) (0.58)
Variable
cost (£m)
(0.25) (0.52) (0.58) (0.66) (0.68) (0.35)
Net
Cashflow
(£m)
(2.50) 0.25 1.02 1.22 1.43 1.48 0.47
Week 5 4
Payback periods
The first way of evaluating this project is to calculate the
payback period. How long does it take you to get back the
initial £2.5m?
By the end of year 1 you will have £0.25m
By the end of year 2 you will have £1.27m
By the end of year 3 you will have £2.49m
You need £2.5m to payback the initial investment. So, a
further £2.5 - £2.49m = £0.01m is needed. The payback
period is therefore almost exactly 3 years.
The advantage of using the payback period for evaluating
projects is that it is simple and may be useful for companies
that have serious problems with cash flow management.
There are many disadvantages. It takes no account of the time
value of money. It penalizes long-term projects in favour of
short-term projects.
Week 5 5
Discounting the cashflows
When evaluating this project, the time value of money should
be taken into account.
First, we will discount the cashflows at the “required rate of
return”. The risk-free rate is 5% and you require an 8% risk
premium for this project. In other words, the “required rate of
return” (or “discount factor”) for this project is 5% + 8% =
13%.
Using this to get the “discounted cashflows (DCF)”
Year 0 1 2 3 4 5 6
Net
Cashflow
(£m)
(2.50) 0.25 1.02 1.22 1.43 1.48 0.47
Discount
factor
1 0.885 0.783 0.693 0.613 0.524 0.480
DCF
(£m)
(2.50) 0.22 0.80 0.85 0.88 0.78 0.23
The first thing we can do now is calculate the discounted
payback period. Using the DCF numbers it is apparent that
the discounted cashflows pay off the initial investment in 3
years and 8.6 months.
Week 5 6
Net Present Value (NPV)
The next way of doing the analysis is just to add up all the
DCFs to get the net present value (NPV).
NPV = (2.50) + 0.22 + 0.80 + 0.85 + 0.88 + 0.78 + 0.23
= £1.26m.
The decision rule based on NPV analysis is:
Positive NPV Good project
Negative NPV Bad project
Given that this is positive, this appears to be a good project.
As we will see below, NPV analysis will be our chosen
method of project appraisal. Before we reach this conclusion,
though, we must consider some alternatives…
Week 5 7
Internal Rates of Return (IRR)
Rather than discounting at 13% and then calculating the NPV,
the alternative is to see what discount rate would give an NPV
of zero. This is called the internal rate of return (IRR).
Using the Tools/Goals Seek method in Excel that we saw in
week 1 we can work out the IRR. It is 27.67%. As this is
above the “hurdle rate” of 13%, we should undertake this
project.
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
0% 5% 10% 15% 20% 25% 30%
Discount rate
NPV
Week 5 8
Changing the project
Suppose that, we can secure a further order from a customer
that will be worth £4m in revenue at the end of the third year.
This will lead to additional incremental costs of £7.4m.
However, we can defer these costs to £2.9m at the end of the
fifth year and a further £4.5m at the end of the sixth year.
Does this new order make the project more or less attractive
to us?
It is “obvious” that this is a bad deal. The effective rate of
return that we are paying on this new order is:
3)1(
5.4
2)1(
9.24
rr +
+
+
=
Solving, r = 26.94%. For a project with a discount rate of
13%, this effective interest rate of 26.94% that we are paying
to secure the new order is clearly too high.
How does this look if we put it into our project analysis?
Payback is now clearly within three years, as the cash inflow
from the new order will pay off the initial investment.
Week 5 9
Changing the project - 2
Consider the cashflows now:
Year 0 1 2 3 4 5 6
Project
Cashflow
(2.50) 0.25 1.02 1.22 1.43 1.48 0.47
New
order
4.00 (2.90) (4.50)
New net
Cashflow
(2.50) 0.25 1.02 5.22 1.43 (1.42) (4.03)
Discount
factor
1 0.885 0.783 0.693 0.613 0.524 0.480
DCF
(£m)
(2.50) 0.22 0.80 3.62 0.88 (0.74) (1.93)
The NPV is now –2.50 + 0.22 + 0.80 + 3.62 + 0.88 – 0.74 –
1.93 = £0.35m
This NPV is lower than it was without the new order (when
the NPV was £1.26m). Therefore, the decision rule that the
higher the NPV the better the project works in this case.
Week 5 10
Changing the project - 3
If we work out the IRR of the project, though, there are two
problems.
1) There is an internal rate of return = 28.70%. This is
higher than the IRR without the new order (which was
26.94%). So, higher IRR does not mean better project.
2) There is a second IRR of 0.142%. That is, the IRR is not
unique. What does this mean?
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0% 5% 10% 15% 20% 25% 30%
Discount rate
NPV
Week 5 11
Multiple IRRs
When, and why, do we have this problem of multiple IRRs?
This arises when, after the initial investment, the net
cashflows are sometimes positive and sometimes negative. In
this example, the net cashflows start positive and end
negative.
As the discount rate increases this has two offsetting effects:
1) It makes the cashflows from the project less valuable in
present value terms
2) Our obligations in years 5 and 6 also have a lower
present value.
Therefore, there are offsetting effects from increasing the
discount rate. That is why the last graph is strangely “non-
linear” and why multiple IRRs exist.
The more often the net cashflow changes between positive
and negative, the more IRRs can potentially exist.
Week 5 12
Accounting ratios
Some managers like to evaluate projects on the basis of
accounting ratios. For example, you could calculate a return
on capital employed (ROCE) each year:
ROCE = Accounting profit after depreciation and tax
Book value of capital employed at beginning of
year
There are several reasons why this method is not favoured in
finance. First, and most importantly, this number depends on
somewhat subjective accounting conventions. Second, as
this ratio varies year by year, it is not clear how to interpret it.
The finance community prefers to use cashflows rather than
accounting profits since cashflow numbers are
uncontroversial.
This technique is still quite commonly used in practice,
however, as many senior finance directors come from an
accounting background and are more confident dealing with
accounting numbers than projecting cashflows.
Week 5 13
In summary
We have looked at four possible methods of evaluating
projects.
1) NPV
2) IRR Problem with multiple IRRs
3) Payback period Undervalues long-term projects
4) ROCE Subject to accounting conventions
The preferred method is NPV because:
a) The decision rules are easy. You should (should not)
undertake the project if the NPV is positive (negative).
The higher the NPV, the better the project. It is unique.
b) The technique is identical to the methods that we used to
price Treasury securities and the discounted dividend
model for valuing stock. The discounted cashflow
method is a general method of valuing investment
opportunities
c) There is no subjectivity over accounting conventions.
d) For those of you who like a very solid theoretical
grounding for your methods, there is a “fundamental
theorem of asset pricing” which demonstrates
unambiguously that the NPV method is “correct” when
excluding project flexibility.
Week 5 14
What do practitioners actually use?
Graham and Harvey (2001, Journal of Financial Economics)
undertake a major survey of US corporations to see what
corporate finance practices they actually use. They find that
the following proportion of CFOs “almost always” use the
following techniques1:
Technique % managers using
IRR 76%
NPV 75%
Payback period 57%
Sensitivity analysis 52%
Discounted payback 29%
Real Options 27%
ROCE 20%
We will return to real options later in the course.
1 Other methods are also used by corporations, but these are much less important than NPV / IRR.
Week 5 15
The fundamentals of NPV analysis
There are three steps that must be completed before we can
undertake an NPV analysis:
1) We must estimate the expected pre-tax cashflows from
the project for each period between the date that the
project is started and the date it terminates.
2) We must calculate the tax implications of these
cashflows.
3) We must calculate the appropriate discount rate to use.
For the rest of this class we shall concentrate on the
fundamentals of estimating pre-tax cashflows.
Week 5 16
Inflating the cashflows
In the example given above, it was emphasized that we had to
inflate the cashflows.
Why?
The required rate of return was calculated by adding a risk
premium of 8% onto the risk-free rate of 5%.
But this risk-free rate of 5% includes an inflation term of 3%
and a real risk-free rate term of 1.94% (From Fisher’s
theorem, 1.05 = 1.03 x 1.0194). That is, the discount rate
includes the inflation component already.
To be consistent, therefore, we need also to include the
inflation element into our cashflows. This is called “nominal”
discounting – we include inflation in both the discount rate
and the cashflows.
Week 5 17
Real vs. nominal analysis
Some people do “real” discounting – that is, they remove the
inflation component from the discount rate and then do not
inflate the cashflows. If done correctly this should always
give the same answer.
My advice, though, is to do nominal analysis. The main
reason for this is that certain cashflows do not inflate
whatever happens to the inflation rate. In the example given
above, the cashflows to and from the venture capitalist are not
inflated.
Of particular importance will be tax-related cashflows.
These never inflate. So, if you do real analysis, not only do
you have to deflate the discount rate, you also need to deflate
certain cashflows.
So, while doing “real” analysis is completely correct if done
properly, my view is that you are more likely to make
mistakes this way. For this reason, all the examples in this
class will be done nominally.
Week 5 18
What cashflows do we discount?
We define the relevant net pre-tax cashflows as follows:
Pre-tax = Cash received from sales
Cashflow - Cash paid out on operating expenses
- Capital outlays as they occur
- Increases in net working capital
Or, comparing with profit:
Pre-tax = Earnings before interest and tax
Cashflow + Non-cashflow expenses (mainly depreciation)
- Capital outlays
- Increase in net working capital
Key differences:
1) Cashflow takes the full amount of investment on the date
the cost is incurred and does not depreciate them.
2) Costs and revenues are included on the date when the
cash is paid/received and not on the date when they
accrue.
3) Spending cash to increase inventory is considered a
cashflow even though this has no effect on profit.
4) Interest payments are not taken into account.
Week 5 19
Key issues in cashflow estimation
1) Because cashflows are considered on the date that they
are paid/received, sunk costs are never included in NPV
analysis. These cashflows are in the past already.
2) When evaluating a project, it is the incremental
cashflows that are important. The cashflow that should
be discounted is the difference between what we expect
to receive if we undertake the project compared with
what we would expect in the absence of the project.
3) Incremental cashflows should include the opportunity
cost of cashflows lost as a consequence of starting a
project.
4) NPV analysis should be undertaken from a corporate, not
a divisional perspective. Whether these cashflows occur
in your division or not is irrelevant.
5) For this reason, the allocation of costs is completely
irrelevant to NPV analysis.
Week 5 20
“Practical” cashflow estimation
While the appropriate technique for estimating cashflows
varies widely from industry to industry, there are certain
general rules that can be used.
In particular, it is often possible to estimate cashflows with
some precision in the short term. It is then difficult to make
predictions as to what will happen in the longer term.
For this reason, we need to worry about “terminal value
calculations” – how we estimate the value of the project in the
distant future.
So suppose that we are able to make accurate profit forecasts
for the next seven years, and that, in year 7 we will be making
net operating cashflows of £1m per year. Assume that we are
discounting the cashflows at 13% per year – reflecting a 5%
risk-free rate and an 8% risk premium.
Week 5 21
Terminal values
There are several assumptions that we could make:
1) Assume that there are no more profits to be made. In this
case the NPV just comes from the first seven years.
2) Assume that the operating cashflows are going to decline
– say straight line – to zero in say year 12. In this case,
the NPV is the present value for the first seven years plus
Year 8 Year 9 Year 10 Year 11 Year 12
Cashflo
w
800,000 600,000 400,000 200,000 0
Discount 0.376 0.332 0.295 0.261 0.231
PV 301,000 200,000 118,000 52,000 0
Therefore, this gives an NPV of 671,000 more than
method (1)
3) Assume that profits will decline slowly indefinitely.
That is, assume that the decline in net cashflows will be,
say, 5% per year on a declining balance basis. In this
case, we can use the Gordon Growth Formula to get the
terminal value. In terms of year 7 pounds, the terminal
value will then be:
000,280,5)05.0(13.0
05.01*000,000,1 =
−−
−
Week 5 22
Terminal values - 2
3...) This, though is in terms of year seven pounds. So, in
year 0 pounds, this is equivalent to
000,240,27)13.1/(000,280,5 = . This gives a much higher
PV than methods (1) and (2)
4) We could use the annuity formula to assume that
cashflows will remain unchanged for, say, a further 5
years and then decline.
5) Any combination of these things.
What I am trying to demonstrate here is that whether we get a
positive NPV or not is often a factor of what terminal value
assumptions we make. But, almost by definition, the terminal
value is the hardest thing to estimate. This is a major problem
with NPV analysis.
Week 5 23
Manipulated NPVs
Sometime managers have an incentive to “fix” their NPV.
You should be aware of some of the tricks that they play. The
easiest number to manipulate on an NPV is the terminal value.
Therefore, when I am evaluating someone else’s NPV this is
the first number that I look at. Essentially, I am very wary
when “too much” of the present value comes from terminal
cashflows. In some cases it can be as much as 50% of the
total present value.
This is clearly worrying and I would be very reluctant to
accept such a project without seeing a detailed analysis of
why the cashflows were taking so long to come through.
So, beware. Do not spend 99% of your analysis time
estimating cashflows for the first few years and then 1% of
your time “throwing in” a terminal value – particularly if the
terminal value accounts for a large proportion of the total
present value. This is a very common mistake in practice.
Week 5 24
Sensitivity analysis
Hopefully, by now, you are realizing that there is a great deal
of subjectivity when doing NPV analysis. How are you going
to estimate your cashflows? What terminal value assumption
do you make? …
For this reason, it is strongly recommended that you do
sensitivity analysis when undertaking NPV analysis. Try
different scenarios. Under what conditions is the NPV
positive and when is it negative? What is the worst (realistic)
case? What would be the consequences in the worse case?
That is, rather than accepting all projects with positive NPV
and rejecting projects with negative NPV (the most naïve
textbook approach), this technique should be used as a tool to
help you make a management decision. Certainly, the more
positive the NPV the more optimistic you should be about the
project. But you should carefully consider the assumptions
made in doing the analysis, consider how robust these
assumptions are and what will happen if things do not go
according to plan.
Week 5 26
Question set 4
1) Work out the payback period, the NPV and IRR of the following project.
Assume that there is no taxation. The nominal discount rate is 15% and
the inflation rate is 3% per year into the foreseeable future. Should you
undertake the project or not?
The project requires immediate capital investment of £250,000. Sales in
year 1 are expected to be 5,000 items. In year 2 sales will increase to
10,000 items. From years 3 to 6, sales will be at 20,000 items a year.
There will be no more sales after year 6. It is expected that, in year 1, each
item will sell for £75. The expected fixed cost of production in year 1 is
£500,000 with a marginal cost of production of £35 per item. All costs
and revenues are expected to increase in line with inflation.
2) How does the NPV that you calculated in question 1 change if the firm
needs to hold 15% of annual sales (in value terms) in inventories?
3) How does the NPV that you calculated in question 2 change if you have
already invested £100,000 in management consulting fees in preparation
for this project?
4) How does the NPV that you calculate in question 3 change if, for each
item you sell, another division within your organization loses £1 in profit
(in terms of year 1 pounds) because you are “cannibalizing” some of their
sales.
5) How does the NPV that you calculated in question 4 change if you are
allocated with £100,000 of central overheads per year?
6) How does the NPV that you calculated in question 5 change if you assume
that, instead of sales going to zero after year six, the net cashflows from
question 1 decreases at 10% per year (after adjusting for inflation)
indefinitely but that there are no cashflow implications from (2) – (5) after
year 6?